0:09

so basically what happens

when your return on asset

is the discount rate for your tax shield

things get very simple so Ra is a weighted average of Re and Rd

without 1 minus TC next to the debt and

same with beta assets so we have done on levering

and what I want to do next is just kinda

put some structure around what we've been talking about

and it’ll be a very short segment bottom line of unlevering

which approach is more reasonable to use approach one

where you assume Rd is the discount rate for TS or approach two

where Ra is the discount rate for

TS obviously the answer depends

and most of the time I think it's

okay to use Ra because the value of the firm

and the value of the tax shield kind of are related and that's just I’m just

giving it out as a

measure more of suggestion more of convenience if you may

rather than fine-tuned answer which approach is consistent with the use

of WACC

and I think I gave you a hint a little while ago that the

WACC if you focus on a specific debt to equity ratio

and let’s suppose it’s 30 percent

what will happen you start off with thirty percent

of debt in your total capital structure and suddenly

you start your firm firm value will change

in the future almost 100 percent and the reason is

news new news and life so the value of the project

changes every day if you open up the stock market does the stock price change every

second

yes sometimes you wonder what is this news coming

you know it's called noise or whatever

so yeah stock prices change if stock price changes

value of the firm changes and the debt to equity

debt to equity ratio changes and if you want a specific

targeted debt to equity ratio you change the level of debt

so you can refine this process a lot but the fundamental point here is the

discount rate for

the tax shield would probably the better used one is Ra

if you're using something consistent with WACC

what is the outcome of unlevering

so we did unlevering

what was the outcome we wanted this is a very interesting question because it’s

key

the outcome is getting Ra

and this is the return regardless of what you may assume

about the unlevering process this is the return you’re after

and typically you get there through the

liability side of the balance sheet okay

calculation of WACC and

once we’ve done WACC we’ll kind of

pause there and the reason why we're doing WACC is

weighted average cost of capital is now

for your firm so we're going from Ra

to U and the most valued

most often used technique

is enterprise value and for enterprise value you need

weighted average cost of capital we will do all valuation methods

with an example but okay so how do you calculate weighted average cost of

capital

what do you need to calculate it well to

do weighted average cost of capital you need Re

you need Rd and you need

weights but you also need

tax rate and for which company am I talking about now

I’m talking about you remember you were looking at another comparable you got

the Ra

and to go to your WACC you have to start thinking about your capital structure

so the information you need is the weights or

debt over equity that’s another way to think about it

so you need the weights you need the Re

Rd and you need the tax rate calculation of WACC

okay so putting it all together

WACC would be Re

E over D plus E Rd

and I'm going to keep a gap here so that you're now thinking of

your WACC

your weighted average cost of capital right because that's the relevant one

why did I keep a gap here one there should be a positive sign

and this 1 minus TC

okay so what do I need to do

do you see an Ra here and if you know from the past you don't

see an Ra weighted average cost of capital’s

thing I don't like about is it incorporates the

tax benefit in the discount rate

of tax benefit of taking on debt wheras I like

APV because it separates the two out so just jumping ahead

what is the discount rate you need for APV

Ra for value of the project and then Ra or Rd depending on what you

want to do with your debt

what do you need for equity holders the evaluation

you need Re so let's talk about Re

this

is your capital structure

your capital structure and let's call it the ratio D over E

because if you know D over E you know the proportion of debt

too because what is the proportion of debt D over D plus E

so if you know D over E you can easily go to D over D plus E

okay so you need that we’ll need that information

that's a strategic decision of your capital structure

Rd is relatively easy because you need to know what is the

debt you’ll take TC is relatively easy

the trick is you need to figure it out

Re and here's where things will get a

little bit tricky you need to figure out

Re to throw it in here so please remember that

without knowing Re you cannot figure out WACC

and why do you need to know Re because you

need to figure out the return on equity to be able to figure out weighted average

cost of capital and you know the Ra

now from your comparable

I'm going to be a little painful Ra from your comparable you know

but this is your return on equity

quick question will your return on equity be the same

as the return on equity of the comparable

struggle with it a little bit will your return on asset

your business be related to the return on assets of your comparable will it be the

same

think about it so the issue then becomes

you need to start relevering

Ra to get to your Re

if you thought about it for a second what you’re going to do now is you're going to

take the Ra

and run with it only if you're using the first part of

APV otherwise your can’t so to get to

Ra to Re you have to now re-lever

which is a little bit of a pain okay so let's stop here

and just remember that weighted average cost of capital

requires you to re-lever and figure it out

and then figure out WACC we’ll do that all

when we do the valuation methods and once we do all the valuation methods together

we’ll do a detailed example take care

I want to leave you with WACC and one last comment before I forget

if you know how to do WACC and you know how to do return on equity to

do WACC you know also how to do the equity valuation method

why because equity valuation method uses

Re to value the equity and adds back the

debt take care see you

with valuation methods in application

as the next module bye now